Three Big Reasons Oil Prices Will Resume Their Rally

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[Editor's Note: This report on the global oil market is the latest installment in a series of Money Morning quarterly reports that will examine such topics as gold, housing and U.S. equities. These reports will now be a regular feature at the end of each quarter.]

By Jason Simpkins
Managing Editor
Money Morning

Oil has staged an impressive rally since dropping below $35 a barrel in mid-February, soaring 42% in little more than a month to about $50 a barrel.

And while there remains a risk that prices will retreat further due to sluggish demand, there are also three very compelling reasons why oil is still a safe long-term bet:

OPEC has made substantial progress in reducing the amount of oil on the market.

The dollar has been made vulnerable by the U.S. Federal Reserve's aggressive policy of quantitative easing.

There's no question that downside risk remains. On April 13, the Paris-based International Energy Agency (IEA) lowered its demand forecast by 1 million barrels a day, and now expects the world will use about 83.4 million barrels per day in 2009. That would be 2.4 million barrels a day, or 2.8% less than last year.

But so far dwindling demand has failed to contain oil prices.

The futures contract for benchmark crude settled at $49.66 a barrel on March 31, up 11.3% from where it ended 2008. As Money Morningpredicted in its annual outlook series, the first quarter was a volatile one, in which oil prices tested the low $30s before surging over $50 in recent market rally.

And analysts are almost completely united in the view that, despite its short-term volatility, declines in production, exploration and development, and the value of the dollar will drive oil prices substantially higher in the years ahead.

OPEC Keeps a Lid on Production

The members of OPEC generated tremendous revenue from oil prices that soared over $147 a barrel last year. However, just as the world's top oil producers began looking for ways to spend their massive stockpiles of cash, prices began a plunge that would see crude lose more than three-quarters of its value.

In a desperate effort to put a floor under oil prices, OPEC – supplier of 40% of the world's oil – has issued three production cuts totaling 4.2 million barrels per day (bpd), or nearly 12% of its capacity, since September.

While the cuts have not yet been able to return oil prices to the group's desired price range of $60-$70 a barrel, the cartel abstained from making any further reductions at its latest meeting in March and even voiced optimism that crude would reach $60 a barrel by the end of the year.

Many analysts had speculated that OPEC members would ignore the quotas and continue to produce oil to generate income, thereby rendering the cuts ineffective. But OPEC's discipline has proven many critics wrong.

Despite foot-dragging from Iran and Venezuela – two countries that rely heavily on oil revenue to fund massive social programs – OPEC has gotten about 80% compliance on the 4.2 million bpd production cut. Historically, the cartel only gets about 60% compliance on such cuts.

As of February, Saudi Arabia accounted for about 46% of the 3.4 million bpd decline in production, according to PFC Energy. And the United Arab Emirates have fully complied with their share of the cuts. Iran's compliance by that time was only 33% and Venezuela had only adhered to half of its commitments.

OPEC officials from Libya, Algeria, and Iraq have all said that oil prices will reach $60 a barrel by the end of the year.

"One of the reasons why OPEC felt able to roll over quotas was that they do appear to have set a floor for prices," Mike Wittner, an analyst at Societe Generale SA (ADR: SCGLY), told Reuters. "According to a lot of the balances, including ours, if you have OPEC holding steady or cutting a bit more, you get a big, counter-seasonal stock draw in the third quarter."

Crude Thrives on the Diving Dollar

Crude futures doubled from July 2007 to July 2008, soaring from about $74 a barrel to a record-high $147 a barrel. Much of that rise can be attributed to supply and demand, but there was another catalyst for the soaring prices that few investors recognized: The rapid decline of the dollar.

From July 2007 to July 2008 the dollar plunged 16% against the euro. And as the dollar became less valuable the cost of commodities around the world skyrocketed.

At the time, inflation – not deflation – was the predominant concern among the world's leading economists, as a decade of low interest rates and unconstrained lending in the United States sucked the life out of the dollar. And while inflation is nowhere near the levels it reached last year, it's important to recognize that the policies of the U.S. Federal Reserve are no less inflationary.

The Fed has cut its benchmark lending rate to a range of 0%-0.25%, and last month, Fed Chairman Ben S. Bernanke said the central bank would purchase up to $300 billion of longer-term Treasury securities and $750 billion of mortgage-backed securities as it pursues a policy of quantitative easing.

This announcement by the Fed, along with a corresponding rise in equities, has been the driving force behind oil's recent rally.

"[Oil prices] are being possessed by the dollar and the stock market," Phil Flynn, an analyst at Alaron Trading Corp. told The Associated Press. "It's not an oil market anymore. It's a stock-currency market because that's what we're reacting to right now."

Ultimately, the same fear of inflation that typically drives investors into the gold market is similarly buoying oil prices. And even though the dollar has yet to be seriously affected, there's no ignoring the fact that its value has been imperiled.

The Coming Oil Price Shock

Now that a weak dollar and reduced production have bolstered oil prices, there is a growing concern about how much higher crude will climb once demand returns. Tighter lending conditions and a trough in oil prices have badly crimped investment and jeopardized future supplies.

More expensive energy projects such as oil sands have been put on hold and the number of drilling rigs at marginal shallow-water fields around the world has been scaled back to a three-year low.

Oil drilling activity dropped 43% in the 12 months through March, with year-over-year oil exploration in the United States alone down 38%. High bids for offshore drilling rights in the central Gulf of Mexico fell by more than 80% compared with last year.

OPEC has said that with oil generating substantially less revenue as many as 35 new projects could be delayed past 2013.

"I have often described unsustainably low oil prices as carrying the seeds of future spikes and volatility. In a low-price environment, the trend is often to focus on survival instead of expansion," said Ali al-Naimi, the Saudi oil minister. "If we place a low priority on preparing for the future, that lack of action can come back to haunt us through supply shortages and another round of high prices."

CERA now says that production will grow by just 7.5 million bpd over the next five years, down from the 14.5 million bpd increase it predicted last summer. According to the research group, as demand recovers throughout that span, production will struggle to keep up and a new commodities bull market, similar to the one seen in 2008 will begin.

"Seven consecutive years of rising oil prices – unprecedented in the history of the oil industry – have come crashing down, thus burying the notion that the commodity price cycle was a historical relic," said the report.

CERA isn't the only organization worried about the lack of investment in new oil projects, either. The International Energy Agency (IEA) – energy advisor to 28 industrialized nations – has also issued warnings about a coming supply crunch.

The IEA estimates daily oil demand will rise from the current level of 86 million barrels to 106 million barrels by 2030. To meet that demand, the agency estimates that the world needs $26.3 trillion in supply-side investments over the next 21 years.

China, India and other developing countries, alone, will need investments of $360 billion a year through 2030, the agency said.

About 7 million bpd of additional capacity needs to be added to the market by 2015.

"Unless sufficient companies have the will and financial ability to invest through the downcycle, there is a real risk that supply growth may lag the eventual rebound of demand, leading to substantial price increases – possibly as early as this year," Richard Jones, the IEA's executive director said at a recent conference in London.

Jones estimates that as much as 2 million bpd of expected new oil production has already been deferred.

The IEA predicts that, by 2015, a lack of investment and rising demand will create a "supply crunch" – that will once again send oil prices up into the triple digits.

"There remains a real risk that under-investment will cause an oil supply crunch in that time frame," the IEA said in an executive summary of its "2008 World Energy Outlook." "The gap between what is currently being built and what will be needed to keep pace with demand is set to widen sharply after 2010."

The agency predicts that crude will average more than $100 a barrel from 2008 to 2015 and rise above $200 a barrel by 2030, as demand far outpaces supply.

"Every bull market in oil is really born in the zenith of a bear market," said Alaron Trading Corp.'s Flynn. "The cutbacks we see today are going to lead to a spike somewhere in the future. The big question is when it's going to happen."

"Despite foot-dragging from Iran and Venezuela, two countries that rely heavily on oil revenue to fund massive social programs, OPEC has gotten about 80% compliance on the 4.2 million bpd production cut. Historically, the cartel only gets about 60% compliance on such cuts."

Not mentioned was that funding revolutions in other countries also consumes much of their oil revenue. Half truths give wrong impressions to the uninformed and create doubt about the author's credibility in the informed.

Assuming there is no bias by the author, proof reading for content could be a solution.

While I agree that in the long term oil prices will be significantly higher than they are now, do you think there will be better buying opportunities in the short and medium term?

As good as 80% compliance is for a month or two, I just don't think that OPEC countries can afford to maintain that for very long. As some point, some of these countries are going to have to cheat to fund their budgets and prevent social unrest.

Can they hold out until the oil consumers' economies recover in 6+ months?

Thanks a lot for your interest. This is a very positive piece about oil, which many analysts – including myself – believe looks very attractive long-term. But I want to be as honest and candid as I can about the potential downside.

There is very good chance that oil will slide back to $40 a barrel somewhere in the short or medium term.

Alaron’s Phil Flynn is on the money when he said that oil prices are “possessed by the dollar and stock market.” We are enjoying some very positive sentiment regarding a recovery, as well as a market rally that makes it look as though risk appetite is returning.

But there is still very very little demand for oil at the present time and it doesn’t look like demand will make a particularly strong rebound in the near future.

It’s reasonable that some unforeseen, negative event could cripple this momentum and suck the air back out of the oil market. So, depending on what particular situation an investor is in, it might not be a bad idea to wait for a pullback.

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